Valuation and Underpricing of Initial Public Offerings: Role of Discretionary Accounting Accruals

Abstract

This study examines the role of pre-IPO discretionary accruals in the valuation and underpricing of IPOs. We find that the underwriter offer price is unaffected whereas the market closing price is positively associated with the levels of pre-IPO discretionary accruals for issuers with aggressively reported earnings. We also find that this relative over-valuation of managed earnings by the markets explains a portion of the initial return that is not explained by other known determinants. For issuers with conservatively reported pre-IPO earnings, there is no relation between discretionary accruals and the offer price or the market price, and that the discretionary accruals do not explain any IPO underpricing. Our subsequent analysis shows that lower stock retention appears to be a screen and a signal of entrepreneurs’ credibility to the markets. There seems to be a higher degree of earnings scrutiny by both the markets and the underwriters for IPOs with low insider retention. However, markets tend to assign higher weight to aggressively reported earnings of issuers with higher insider retention, presumably because of perceived incentive alignment. Underwriters, with relatively lesser information asymmetry than the markets, tend to see through the distortions caused by earnings manipulations in the valuation of IPOs, regardless of the levels of issuers’ stock retention.